RBI Bars Regulated Entities from Investing in AIF Schemes with Downstream Investments in Debtor Companies

Key Takeaways:

1. Regulated entities are prohibited from investing in AIF schemes with downstream investments in their debtor companies.

2. Existing investments in such schemes must be liquidated within 30 days.

3. Failure to liquidate investments will result in a 100% provision requirement.

4. Investments in subordinated units of AIFs with priority distribution models face full capital deduction.

5. The guidelines are effective immediately, impacting all commercial banks, co-operative banks, financial institutions, and NBFCs.

Detailed Narrative:

The Reserve Bank of India (RBI) has issued new guidelines governing investments in Alternative Investment Funds (AIFs) by regulated entities (REs) to address regulatory concerns.

These guidelines, effective immediately, aim to curb the practice of loan evergreening through indirect exposures via AIF investments.

The circular, numbered RBI/2023-24/90 and dated December 19, 2023, outlines several key provisions that will reshape how banks, financial institutions, and non-banking financial companies approach their AIF investments.

The primary focus is on preventing REs from substituting direct loan exposures with indirect exposures through AIF units.

Under the new rules, REs are strictly prohibited from investing in any AIF scheme that has downstream investments, either directly or indirectly, in a debtor company of the RE.

For clarity, the RBI defines a debtor company as any entity to which the RE currently has or has had a loan or investment exposure within the preceding 12 months.

The guidelines also address scenarios where REs have existing investments in AIF schemes that subsequently make downstream investments in debtor companies.

In such cases, REs are required to liquidate their investments in the scheme within 30 days from the date of the downstream investment by the AIF.

This 30-day liquidation period also applies to existing investments that fall under this category as of the circular's issuance date.

Recognizing the potential challenges in liquidating investments within the prescribed timeframe, the RBI has introduced a stringent provision requirement.

If an RE fails to liquidate its investments within the 30-day period, it must make a 100% provision on such investments. This measure serves as a strong deterrent and ensures that REs take prompt action to comply with the new regulations.

The circular also addresses concerns related to priority distribution models in AIF schemes.

Investments by REs in subordinated units of any AIF scheme with a priority distribution model will be subject to full deduction from the RE's capital funds.

The RBI refers to the Securities and Exchange Board of India (SEBI) circular SEBI/HO/AFD-1/PoD/P/CIR/2022/157 dated November 23, 2022, for the definition of 'priority distribution model'.

These guidelines have been issued under the authority vested in the RBI by various legislative acts. Specifically, the instructions draw their power from Sections 21 and 35A of the Banking Regulation Act, 1949 (read with Section 56 of the same Act), Chapter IIIB of the Reserve Bank of India Act, 1934, and Sections 30A, 32, and 33 of the National Housing Bank Act, 1987.

The immediate effectiveness of these instructions underscores the RBI's commitment to addressing regulatory concerns promptly and decisively. All regulated entities, including commercial banks (such as Small Finance Banks, Local Area Banks, and Regional Rural Banks), Primary (Urban) Co-operative Banks, State Co-operative Banks, Central Co-operative Banks, All-India Financial Institutions, and Non-Banking Financial Companies (including Housing Finance Companies), are required to comply with these new regulations without delay.

This regulatory move is expected to have far-reaching implications for the financial sector, particularly in how REs manage their investment portfolios and their relationships with AIFs. It reflects the RBI's ongoing efforts to strengthen the financial system and prevent potential misuse of investment channels for evergreening of loans.

FAQs:

1. Q: What is the main purpose of these new RBI guidelines?

A: The main purpose is to prevent the evergreening of loans through indirect exposures via investments in Alternative Investment Funds.

2. Q: Who does this circular apply to?

A: It applies to all regulated entities, including commercial banks, co-operative banks, financial institutions, and NBFCs.

3. Q: What happens if a regulated entity can't liquidate its investment in an AIF scheme within 30 days?

A: If liquidation isn't possible within 30 days, the regulated entity must make a 100% provision on such investments.

4. Q: How does this circular affect investments in AIFs with priority distribution models?

A: Investments in subordinated units of AIFs with priority distribution models will be subject to full deduction from the regulated entity's capital funds.

5. Q: When do these new guidelines come into effect?

A: The guidelines are effective immediately from the date of the circular (December 19, 2023).

Key Precedents:

1. Banking Regulation Act, 1949 (Sections 21, 35A, and 56): These sections provide the RBI with the authority to issue directions to banking companies for public interest and to regulate the banking system.

2. Reserve Bank of India Act, 1934 (Chapter IIIB): This chapter deals with provisions relating to non-banking institutions receiving deposits and financial institutions.

3. National Housing Bank Act, 1987 (Sections 30A, 32, and 33): These sections empower the National Housing Bank to regulate housing finance companies.

4. SEBI Circular SEBI/HO/AFD-1/PoD/P/CIR/2022/157 dated November 23, 2022: This circular defines the 'priority distribution model' for Alternative Investment Funds, which is referenced in the RBI's new guidelines.

These precedents provide the legal framework and context for the RBI's new guidelines on AIF investments, ensuring that the regulations are grounded in existing financial laws and regulations.

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Here's the verbatim RBI Circular

RBI/2023-24/90

DOR.STR.REC.58/21.04.048/2023-24

December 19, 2023

All Commercial Banks (including Small Finance Banks, Local Area Banks and Regional Rural Banks)All Primary (Urban) Co-operative Banks/State Co-operative Banks/ Central Co-operative BanksAll All-India Financial InstitutionsAll Non-Banking Financial Companies (including Housing Finance Companies)

Investments in Alternative Investment Funds (AIFs)

Regulated entities (REs) make investments in units of AIFs as part of their regular investment operations. However, certain transactions of REs involving AIFs that raise regulatory concerns have come to our notice. These transactions entail substitution of direct loan exposure of REs to borrowers, with indirect exposure through investments in units of AIFs.

2. In order to address concerns relating to possible evergreening through this route, it is advised as under:

(i) REs shall not make investments in any scheme of AIFs which has downstream investments either directly or indirectly in a debtor company of the RE.

(ii) If an AIF scheme, in which RE is already an investor, makes a downstream investment in any such debtor company, then the RE shall liquidate its investment in the scheme within 30 days from the date of such downstream investment by the AIF. If REs have already invested into such schemes having downstream investment in their debtor companies as on date, the 30-day period for liquidation shall be counted from date of issuance of this circular. REs shall forthwith arrange to advise the AIFs suitably in the matter.

(iii) In case REs are not able to liquidate their investments within the above-prescribed time limit, they shall make 100 percent provision on such investments.

3. In addition, investment by REs in the subordinated units of any AIF scheme with a ‘priority distribution model’ shall be subject to full deduction from RE’s capital funds.

4. These instructions have been issued in exercise of the powers conferred by the Sections 21 and 35A of the Banking Regulation Act, 1949 read with Section 56 of the Banking Regulation Act, 1949; Chapter IIIB of the Reserve Bank of India Act, 1934 and Sections 30A, 32 and 33 of the National Housing Bank Act, 1987.

5. The above instructions shall become effective immediately.

Yours faithfully,

(Vaibhav Chaturvedi)

Chief General Manager